Author
Homebuyers and economists alike closely watch indicators for changes in home prices. For homebuyers, a change in prices can make the difference between purchasing their dream home or no home at all. For economists, home prices and rent prices together make up the cost of shelter, an important driver of inflation. In fact, a large proportion of the persistent post-pandemic inflation has been driven by the rising cost of shelter.
But what determines changes in home prices, and why does the source of these changes matter? Recent media commentary and research has pointed to the influence of housing supply. A new Institute working paper from Tobias Herbst, Moritz Kuhn, and Farzad Saidi examines another angle: How does the supply of credit shape home prices? In the context of housing markets, the supply of credit can be thought of as how easy or difficult it is for a homebuyer to receive a loan, or how generous the conditions of the loan are. A greater supply of credit means buyers can more easily borrow the money they need to purchase a home. This increase in demand, driven by expanding credit, can then put upward pressure on home prices.
Policymakers have at times considered policies to expand access to credit to support homeownership for groups that have limited access. Given the conversations around these policies, both policymakers and potential buyers have an interest in understanding how expanding credit can affect home prices.
Why the supply of credit is difficult to study
What makes the effect of credit on home prices difficult to study is that lending institutions may alter their expectations as demand for housing increases. If they anticipate that rising demand will cause a rise in prices, then the collateral—the home itself—becomes a safer investment, which would encourage more lending. This feedback loop could then further increase housing demand and prices. While anecdotal, this story demonstrates how both the increase in lending and changing expectations can shape the trajectory of home prices. But economists can observe only the overall increase in prices, not the change from each effect.
To get around this challenge, Herbst, Kuhn, and Saidi study the Veterans Affairs (VA) home loan program, which offers eligible veterans the option to receive generous loans that, for example, require no down payment. The VA loans make up a meaningful share of total loans in the market—between 2 and 10 percent of mortgages each year from 1980 to 2017 were guaranteed by the VA loan program. So, an increase in demand among veterans could drive home prices throughout the entire market. For many veterans, these loans are essential to have the option to buy a house earlier in life, and their generous conditions often allow veterans to purchase higher-priced homes than they could with a loan from the conventional market.
The solution: A natural experiment with VA loans
On April 6, 1991, the criteria determining who was eligible for a home loan from the VA were relaxed so that all veterans who served in the Gulf War became eligible for what the economists classify as “generous” VA home loans. These loans feature a no-down-payment option or extend higher levels of credit relative to a buyer’s income than would be available in the conventional market. This change granted eligibility for over 700,000 service members who deployed in support of operations Desert Shield and Desert Storm between August 1990 and February 1991. Since this expansion of credit was driven by geopolitical decisions around the Gulf War, it was not related to future expectations of home prices or other economic conditions.
For their study, the economists rely on novel data on all loans under the VA loan program.
They find that if the share of generous VA loans within an average county is doubled from 12.5 to 25 homes per 100,000 people, county home prices would increase by an estimated 2.6 percent. For context, the S&P Case-Shiller U.S National Home Price Index increased by an average of 3 percent each year between 1990 and 2000. These results confirm that expanding credit had a meaningful effect on house prices.
The effects also prove to be persistent, though they dwindle over time. The figure shows the estimated cumulative percent increase in house prices across time if the average share of generous VA loans within a county is doubled. For four years, home prices steadily increase, peaking at prices that on average are 9.8 percent higher than they were before the VA loan expansion. Prices then start to decline, and by year seven they are just slightly higher than where they started.
However, the economists also show that the increase in home prices after an expansion of credit varies across geography. Specifically, the growth in home prices depends on how responsive local housing supply is to price changes. In fact, for the average U.S. county, upward of two-thirds of the increase in prices is mitigated by a county’s ability to provide new housing to meet the increase in demand after the credit eligibility expansion. On the flip side, this means that local housing markets that cannot react by expanding housing supply will see stronger increases in house prices after credit expansions.
Expectations and prices
The results show how an expansion of credit in the form of expanded eligibility for VA loans helps drive increases in home prices. But what about the second mechanism, the role of changing expectations? If lending institutions believe that home prices are going to go up, then the value of their collateral goes up, too. This makes houses a better investment, and lenders should want to increase their lending. This expansion of lending should further increase demand and prices.
To test this theory, the economists combined their data with data from the Home Mortgage Disclosure Act and with additional information on the characteristics of both lenders and borrowers. This allowed them to account for factors that are specific to individual applicants, lenders, and regions across time. They found that the estimated 2.6 percent growth in home prices resulting from the credit expansion would lead to an estimated 1 percentage point increase in mortgage approval rates in the conventional loan market. Furthermore, the growth of the number of loans was larger in the conventional market than the VA market and lasted for a longer period.
In short, the VA home loan eligibility expansion had large effects not only for veteran household homebuyers, but also for non-veteran households in those same communities due to increased lending. This suggests that the expansion of credit does indeed increase home prices via a feedback loop.
How is this relevant today?
While much has changed since the Gulf War, this research can help to assess the complex effects of policy proposals to tackle post-pandemic cost-of-living increases. These policies often include mechanisms such as down payment assistance to low-income or first-generation homebuyers, similar to the VA loan expansion. This study shows how such credit expansions could increase home prices not only in the targeted communities but more broadly as well. The economists also identify a factor that mediates the effect on home prices: the ability of local markets to increase their housing supply. These findings contribute further insights around the dynamics of housing prices and potential tools for policymakers to help address housing affordability challenges faced today.
